Decoding Derivatives

• Derivatives have no independent value. Its value is derived from some other asset, which is called the “underlying asset”.
• The underlying asset can be an index, a stock, a commodity, a bullion item or a currency. For example, derivatives of ITC shares will derive its value from the current share price of ITC.
• The underlying asset could be index, stock, commodities bullion or currency.
• Derivative contract is priced separately based on the underlying asset
• The contract is traded not the underlying asset.
• It acts as a good hedging tool against price volatility
• You can take a high exposure on a stock or security by paying a small margin.
• EXAMPLE: If the stocks are priced at Rs 10 lakh and you have only Rs 2 lakhs in hand, this product will still help you take a position.
• It offers huge time leverage, which is a big plus for traders who do margin trading.
• You can hold the position for 3 months. Normal margin product- 1 day, E-Margin product T+2 days

Types of Derivatives

1. Futures: The owner has the obligation to buy or sell a contract at a pre-defined time and price. Conditions are standardised
2. Forward: The owner has the obligation to buy or sell a contract at a pre-defined time and price. Conditions are customised between buyer and seller
3. Option: The owner has the option to buy or sell something at a pre-defined price and time
4. Swap: It is an agreement of barter or exchange of sequence of cash flows

Futures

• It is a contract to buy /sell pre-defined quantities of an instrument at a specified price and time
• Future contract has standardised conditions such as price, quantity and time
• The owner of the contract has the obligation to buy or sell in future
• Price is determined by supply and demand factors in secondary market
• Index futures was the financial derivative launched in India
• Every contract expires on last Thursday of the expiry month

Terminologies used in Futures

• Spot Price: the trading price of the asset in the spot market
• Future price: the price of future contracts in futures market
• Contract Cycle: Validity period for trading in contracts
• Contract Size: Amount of the asset to be delivered in specified time
• Expiry date: The date on which validity of contract ends
• Initial Margin: Amount to be deposited in margin account to start trading
• Maintenance Margin: Minimum amount to be maintained for trading
• Cost of Carry: Storage cost plus interest paid to finance the asset
• Mark to Market: Adjustments (Profit or Loss) made to investor’s margin account based on future closing price

Types of Futures Contracts

In terms of Underlying Asset

• Index Futures
• Stock Futures

In terms of Expiry

• Near Month
• Next Month
• Far Month

Options

• The owner has an option to buy or sell the contract at a pre-defined price
• Purchaser of option has to pay something for this contract – in form of a premium.
• You can sell/write options and receive an option premium from the buyer.
• A seller is obliged to sell/buy an asset if the buyer exercises it on him.

Types of Options

• CALL Option- Right (not an obligation) to BUY the contract
• PUT Option- Right (not an obligation) to SELL the contract
• Index Options – An Index is the underlying asset.
• Stock Options – Stocks act as the underlying asset.

Terminologies used in Options

Please refer our separate blog dedicated on this topic here.

Difference between Futures & Options

• Futures and unlimited profit or loss potential.
• Options have limited risk and unlimited profit potential. (Only applicable to Long positions)